Being aware of the potential financial returns of a rental property is the driving force behind making a wise real estate investment decision.
While good investments mean different things to different people, real estate investors typically measure the profitability of their investments using the return on investment metric. This helps them to figure out the financial returns of property for sale before buying it for real estate investing. But what exactly is ROI? And what is a good return on investment for rental properties?
What Does ROI for Rental Property Mean?
The real estate return on investment (ROI for short) is the standard metric that measures the performance and analyzes the returns of an investment property. It’s simply the profit that a real estate investor gets in comparison to the actual cash he/she has invested in the rental property. This metric is very comprehensive and takes many important variables into account including:
- Annual Rental Income: This is exactly what it sounds like. The annual rental income is simply the gross rental income that your rental property will generate in a year. Real estate investors can calculate their annual rental income simply by multiplying the monthly rental income by 12 or by multiplying the weekly rental income by 52.
- Costs and Expenses: Every real estate investment property comes with different costs and expenses. Some are one-time startup costs (such as closing costs, appraisal, and renovation costs) and some are recurring costs (such as mortgage payments, insurance, utilities, and maintenance). The return on investment on rental properties takes all expenses and costs into account.
- Cost of Property: For real estate investors to truly understand how well an investment property is performing, they must compare its profit to its price (or fair market value). Without doing this, you may be deceived into thinking a rental property is performing well just because it generates high rental income. However, if this income is compared to its price and is insignificant, then the investment property is actually not performing as well as you’ve thought.
When putting these variables together in an equation, the real estate return on investment looks like this:
How to Calculate the Return on Investment
Estimating the ROI on investment properties doesn’t have to be very complicated. Today, real estate investors have access to a number of tools that make their jobs easier. One of which is a tool called the Investment Property Calculator, and it’s used to give you projections of the potential return on investment on any property in the housing market.
Using this tool, a real estate investor can first analyze ROI based on reliable data on rental income, property price, and even costs provided for each investment property. Upon further research, an investor can plug in the above numbers that apply to his/her unique case and immediately get an estimation of the ROI.
The most impressive thing about the Investment Property Calculator is that it shows you the returns in terms of cap rate, cash on cash return, and cash flow! In addition, you can continue to customize the values to estimate the profitability of rental properties and see what is a good return on investment whether you decide to rent them out traditionally or as vacation home rentals on Airbnb.
Where can you find this tool? Right here on Mashvisor, of course! Start out your 14-day free trial with Mashvisor now to give it a try and find profitable properties in the US housing market.
What Is a Good Return on Investment?
In searching for the answer for what is a good real estate ROI, many beginner investors expect to be given a specific number. However, the question “What is a good return on investment?” is subjective and, the truth is, there is no single number labeled as the best return on rental properties. For example, for one investor a 2% ROI sounds great, while another investor would only invest in a rental property if it provides an ROI of 10% or more. Only you can determine what a good return is for you.
A second question that beginner real estate investors ask is “Good ROI as compared to what?” There are certain factors that determine whether the return on investment on a rental property is actually good or not. Not only that, but these factors also affect what your potential ROI will be when investing in real estate. So, what are these factors exactly?
What Factors Affect Your ROI in Real Estate?
1) Real Estate Market
It doesn’t come as a surprise to see that the first factor affecting what is a good return on investment is location – it affects all your real estate investment decisions! Say that one rental property in a neighborhood yields a 5% ROI, but another rental in another neighborhood yields a 7% ROI. If you’re making your investment decision only based on the return, then you’ll choose to buy the property in the second neighborhood.
However, after a real estate market analysis, you might find that property prices in the second location are cheaper due to the lower demand for rental properties. This could possibly mean higher vacancy rates and lower rental income – both are signs of a bad location for owning a rental property! The first location, on the other hand, might have a higher demand and lower vacancy rates.
After comparing the two locations, a smart real estate investor would decide to invest in the first location. Even though the ROI is lower, it’s actually a good return on investment considering the success factors of the location that make for a profitable investment property.
2) Investment Property Financing
There are different ways to calculate the return on investment on a rental property when you look at how you finance the purchase. There are two main investment property financing methods: buying with cash or through a mortgage. As a result, the ROI calculations and what is a good return on investment can differ depending on the method:
- Say that you’re planning on buying a rental property entirely in cash. In this case, you simply use the above formula for calculating ROI: (Annual Rental Income – Costs and Expenses)/Property Price.
- On the other hand, if you, like the vast majority of real estate investors, decide to finance the purchase with a mortgage, calculating ROI has a slight tweak. The ROI formula in this case (also known as the cash on cash return formula) becomes: Annual Cash Flow / Total Cash Invested.
It may seem that this form of the ROI formula is very different from the one used for a cash purchase. However, these two calculations are actually almost the same. This formula uses annual cash flow instead of the difference between annual rental income and expenses and costs. However, annual cash flow is just an extension of the difference – it includes mortgage payments as part of the rental expenses.
The only change in the cash on cash return on investment formula is that it uses the amount of total cash invested instead of the property price. That’s simply because the real estate investor doesn’t pay down the full property price when using a mortgage for financing.
Let’s look at an example to further explain this:
Say you’ve found an investment property for sale with a price of $275,000 and you want to buy it fully in cash. This property will yield an annual rental income of $45,300 and requires $2,000 for annual rental expenses. Following the standard formula, your ROI will be $43,300 / $275,000 = 15.7%.
Alternatively, say you want to finance buying this investment property with a mortgage. You’ve put down a 25% down payment and you’re annual mortgage payments equal $13,332. In this case, your annual cash flow will equal ($45,300 – $2,000 – $13,332 = $29,968). In addition, your total cash invested is $55,000 for the property plus $9,625 in closing costs ($64,625). Following the cash on cash return formula, you’re ROI will be $29,968 / $64,625 = 46.3%
As you can see, both methods of investment property financing have yielded a different ROI. Thus, the answer to what is a good return on investment for rental properties is subjective and depends on which financing method property investors go for.
Note: Mashvisor’s Investment Property Calculator gives you the option to estimate the ROI on the same property whether it’s purchased fully in cash or with a mortgage. Click here to give it a try!
3) Real Estate Rental Comps
To best identify what is a good real estate investment, it’s best to compare your property with real estate comps. Real estate rental comps are properties that are similar to the one you’re considering to buy as an investment property. In order to consider a property a comparable, it has to be similar in terms of:
- Property type (single-family, multi-family, condo, townhouse, etc.)
- Property size (square footage, number of floors)
- Number of bedrooms and bathrooms
- Property’s condition
- Amenities (balconies, fireplace, garden, swimming pool, etc.)
Related: How to Easily Find Real Estate Comps
It’s important to look at real estate rental comps before making any investment decision because they’ll show property investors the average performance of rental properties in the area. In other words, rental comps allow you to see what ROI other similar real estate investments are yielding. Therefore, you can compare that to what your rental property is expected to yield and get a pretty good idea of whether or not it’s a good return on investment.
Mashvisor can provide you with real estate rental comps so you don’t have to do the work yourself!
To find comps and start analyzing the best investment properties in your city and neighborhood of choice, click here.
The Bottom Line
Knowing what is a good return on investment is important for real estate investors of rental properties. It’s important to keep in mind that there is no general number labeled as a good ROI. There are certain factors that come into play and, thus, the answer will differ from one real estate investor to another. Make sure you calculate the ROI on a rental property before making the purchase to ensure you’re heading in the right direction.